An exchange rate is the price at which one national currency can be exchanged for another. The most common currency value notion is the bilateral exchange rate (or simply the foreign exchange (FX) rate) quoted by an FX trader or reported by a quote vendor. This is a nominal exchange rate because it is the number of units of a currency offered in exchange for one unit of another (for example, 1.5 German marks for 1 U.S. dollar). The spot exchange rate is a particular example of a nominal bilateral exchange rate, where the transaction takes place immediately. Another example is the forward exchange rate, where the price is agreed now but the transaction takes place in the future. An FX price is composed of two quantities: a price at which a bidder offers to buy (termed the bid price) and a price at which a seller offers to buy (the ask price).
The bid and ask prices of major financial institutions are conveyed to dealers' screens by quote vendors such as Reuters, Telerate, or Knight Ridder. Deals are typically negotiated via telephone. The FX market operates globally and around the clock. Any market maker may submit new bid/ask prices at any time, and many institutions have branches worldwide, so that they can participate in continuous FX trading.
Although the FX market operates continuously, individual traders or institutions generally participate in this market for only part of each day. There is thus a need for trading models that take take local business hours and holidays into account.
There is a need for trading models that offer real-time analysis of FX-rate movements and generate explicit trading recommendations. A clear distinction should be made between a price change forecast and an actual trading recommendation. A trading recommendation naturally includes some kind of price change forecast, but must also account for the specific risk profile of the dealer or user of the respective trading model. Another distinction is that a trading model must take into account its past trading history, while a price forecast is not biased by a position the trading model might be in. A trading model thus preferably goes beyond predicting a price change: it should decide whether a certain action has to be taken. This decision is subject to the specific risk profile, the trading history, and institutional constraints such as business hours. These different parameters can be integrated into the decision-making process and are important for constructing practical models for professional traders.
There is a further need for models that follow the FX market and imitate it as closely as possible. These models should be based on data from continuous collection and treatment of FX quotes by market makers around the clock (up to 5000 non-equally-spaced prices per day for the German mark, or the euro, against the U.S. dollar). In order to imitate real-world trading accurately, the models also should take into account transaction costs in their return computation, generally avoid trading outside market working hours, and avoid trading too rapidly.